Macroeconomics

A year ago, there was a pervasive mood of gloom among economists and investors about prospects for the global economy in 2016. China was in the doldrums, and fears of a sharp renminbi devaluation were rife. The oil shock had caused major reductions in capital spending in the energy sector, and consumers seemed reluctant to spend the large gains they were enjoying in real household incomes.

Deflation risks dominated the bond markets in Japan and the Eurozone. In the US, the Federal Reserve seemed determined to “normalise” interest rates, despite the rising dollar and the weakness in foreign economies.

At the turn of the year, there were forecasts of global recession in 2016. At the low point for activity and risk assets in 2016 Q1, the global growth rate (according to the Fulcrum “nowcasts”) had dipped to about 2 per cent, compared to a trend growth rate of 4 per cent. It was a bleak period. The dominant regime in financial markets was clearly one of rising risk of deflation.

Since then, however, there has been a marked rebound in global activity, and in recent weeks this has become surprisingly strong, at least by the modest standards seen hitherto in the post-shock economic recovery. According to the latest nowcasts, the growth rate in global activity is now estimated to be 4.4 per cent, compared to a low point of 2.2 per cent reached in March.

The latest growth estimate is the highest reported by the nowcast models since April, 2011 – before the euro crisis and the China slow-down hit global activity very hard. This relatively upbeat take on the current state is supported by alternative data sources. For example, the Goldman Sachs Global Leading Indicator has just reached its highest point since December, 2010.

The uptick in global activity growth has, of course, been accompanied by a rise in headline inflation rates in almost all major economies. Recently, I argued that this jump in inflation was still “weak and patchy”, and almost entirely due to the partial recovery in oil prices, which has been taken further this week by the market reaction to the OPEC decision to reduce oil production.

However, the bond markets have taken the reflation trade increasingly seriously, in part because of the assumed shift towards fiscal easing after the election of Donald Trump in the US. Although the case for a rise in core inflation in 2017 (as opposed to headline inflation) is far from convincing, the recent rebound in global activity may well give the “reflation trade” a further leg upwards.

Morgan Stanley says that investors have stopped asking “is reflation happening?” and instead they are now asking “will it prove sustainable?” It is easy to be sceptical about this. We could be observing nothing more than another short term spike in activity. But, for the moment, the newsflow is clearly improving in a manner that has not hitherto been seen during the faltering “recovery” from the Great Financial Crash. (Full details of the monthly nowcasts can be found here.) Read more

Perhaps the most important among all the many uncertainties surrounding the economic policy of the Trump administration are those related to trade and protection. During the election campaign, the president-elect made blood-curdling promises in this area, and his official campaign documentation was no less strident. If he intends to implement a large part of this agenda in office, the chances of a global trade war would be high.

Last week, trade issues moved to centre stage in the transition. The president-elect released a video confirming that America would immediately withdraw from the Trans-Pacific Partnership, a trade deal that had been intended to be the culmination of President Barack Obama’s political and economic pivot towards Asia.

This was no surprise, since the political supporters of the deal ran for cover during the 2016 elections, but it does mean that any further liberalisation of US trade (including the Transatlantic Trade and Investment Partnership with the EU) is now dead in the water.

It also provides China with a clear opportunity to take the lead in forming an Asian trading bloc, and they have eagerly stepped up to the plate. None of this will have immediate adverse consequences for global markets. It is an opportunity missed rather than a step backwards.

The second big development is the rumoured appointment of Wilbur Ross as commerce secretary (see Gillian Tett). Mr Ross is a business person rather than an ideologue on trade. If anything, he seems to be from the supply side wing of the Republican party. The market would vastly prefer this appointment to a feasible alternative such as Peter Navarro, who is an outright hawk on trade relations with China (and, somewhat ironically, the only PhD economist in Trump’s advisory team).

Although Mr Ross clearly believes that the US should be far more assertive in its trade negotiations with other countries, he has played down the likelihood of dramatic initiatives such as Mr Trump’s threat of a 45 per cent tariff on all imports from China. He has also said clearly that “there will be no trade wars”.

If this turns out to be the dominant tone of the Trump administration, then the tide of globalisation may not be rolled back very far in the next few years, and the global markets will breathe a huge sigh of relief. Read more

The global markets remained in reflationary mode for much of last week, a regime that has now persisted for many months. Led by the US, bond yields have been rising, mainly because inflation expectations are on the increase. Risk assets have been performing adequately, with the exception of the emerging markets.

This reflationary regime has been driven by much stronger global economic activity since mid-2016, and latterly by a belief that Donald Trump’s election victory will lead to US fiscal easing, along with the possibility of the “politicisation” of the Federal Reserve, implying overly accommodative monetary policy.

There are various ways in which this regime could end. The world economy could suddenly go back to sleep, as it has on many occasions since 2009. The US fiscal easing could become bogged down in the Washington “swamp”. Or the Fed could become unexpectedly hawkish, stamping on the first signs of inflationary growth in the American economy. This last risk is probably under-estimated, and is worth considering in detail. Read more

The response of the financial markets to the US election result has been almost as contradictory as the rabble rousing campaign of the President-elect himself. Unmitigated gloom in the hours after the Trump victory was swiftly followed by a euphoric atmosphere in US markets.

Investors are apparently assuming that the new administration will usher in a mix of fiscal reflation, prudent monetary policy, deregulation and tax cuts that will prove very good for the American economy. Trade controls are seen as damaging the emerging economies, but not the US. A steeper yield curve is seen as reflecting a “better” mix between fiscal and monetary policy.

With one very graceful acceptance speech, Donald Trump has suddenly morphed into Ronald Reagan in the markets’ consciousness. Read more

Presidential elections have often marked major changes in American attitudes towards fiscal policy.

The arrival of President Kennedy in 1960 represented the beginning of Keynesian fiscal activism. President Nixon’s election in 1968 marked the high point of inflationary budgetary policy designed to finance the Vietnam War.

President Clinton in 1992 ushered in a period in which the reduction of public debt was paramount. The elections of President Reagan in 1980, and George W. Bush in 2000, marked eras in which tax cuts took precedence over budget balance, and counter-inflation policy was ceded to the Federal Reserve.

As the 2016 election approaches, investors are wondering whether another major change in the approach to fiscal policy is in the works. Is a lurch towards fiscal stimulus the “next big thing” in Washington? Possibly, but I am not convinced. Read more

The great global disinflation in the advanced economies started in 1982, flattened in the 1990s and 2000s, and then nosedived towards deflation as commodity prices collapsed in 2014-15. For much of that final period, deflation fears dominated global bond markets and, to a lesser extent, equities and other risk assets. But there have been signs during 2016 that markets have edged away from a regime of “deflation dominance”, and we have seen partial signs of reflation.

It would be a bold call to claim that the great disinflation of the last three decades is now beginning to reverse. I am certainly not making that call. However, headline inflation is now rising towards the rates recorded before the oil price crash. There are signs that the risk of outright deflation is falling and, in some parts of the developed world, core inflation has edged higher. Read more

James Carville won the Presidency for Bill Clinton in 1992 with a sign in the campaign’s headquarters saying “The economy, stupid”. Maybe there should be a sign in the Federal Reserve saying “Demography, stupid”.

Central bankers, like investors, have usually tended to ignore or underplay the influence of demographic factors over the short and medium term. The size and age distribution of the population changes very gradually, and in a fairly predictable manner, so sizable shocks to asset prices from demographic changes do not happen very often.

That does not mean that demography is unimportant. The cumulative effects can be very large over long periods of time. Apart from technology, there is a case for arguing that demography is the only thing that matters in the very long run. But demographic changes usually emerge very slowly, so they do not trigger sudden fluctuations in the determinants of asset prices, notably the economic cycle and monetary policy.

However, there are exceptions to this rule, and we may be living through an important exception at the present time. It seems that the Federal Reserve is starting to recognise that the decline in the equilibrium interest rate in the US (r*) has been driven not by temporary economic “headwinds” that will reverse quickly over the next few years, but instead has been caused by longer term factors, including demographic change.

Because these demographic forces are unlikely to reverse direction very rapidly, the conclusion is that equilibrium and actual interest rates will stay lower for longer than the Fed has previously recognised. Of course, the market has already reached this conclusion, but it is important that the Fed is no longer fighting the market to anything like the same extent as it did in 2014-15. This considerably reduces the risk of a sudden hawkish shift in Fed policy settings in coming years.

Furthermore, greater recognition of the permanent effects of demography on the equilibrium real interest rate has important implications for inflation targets, the fiscal stance and supply side economic policy. These considerations are now entering the centre of the debate about macro-economic policy. Read more

The sharp decline in sterling since the UK voted for Brexit has been widely viewed by economists as inevitable and, for the most part, desirable. Brexit will probably reduce UK productivity and competitiveness, so living standards will be lower than otherwise. The decline in sterling raises domestic inflation, which is the main route for the necessary decline in living standards to be imposed on the population. It also repairs the loss in the UK’s international competitiveness. The IMF has estimated that a drop of 5-15 per cent in sterling should be sufficient to do the job.

Sterling is now 16 per cent lower than it was on referendum night. What appeared to be an orderly decline in the exchange rate has shown signs of getting out of hand in the wake of the Prime Minister’s speech at Conservative Party conference, in which she appeared to favour a hard Brexit.

This could be a negotiating stance, or it could be a genuine political preference: we will not find out until mid 2019. But markets are saying that a hard Brexit will require a larger drop in sterling to restore equilibrium. This will result in higher inflation than previously contemplated.

Separately, the Governor of the Bank of England appears more willing than before to accept a “temporary” rise in inflation, while keeping domestic interest rates close to zero. The combination of hard Brexit with a super-easy central bank is not a recipe for a strong currency.

There has been some loose talk that this loss of confidence could develop into something really nasty – a sterling crisis. Although the UK has been a serial offender in this regard since leaving the Gold Standard in 1931, I doubt it will happen this time. Read more

Maurice Obstfeld, the Research Director at the IMF, said last week at the IMF/World Bank Annual Meetings in Washington that global growth “remains weak”, but is “moving sideways”. That is an accurate description of the current situation compared to previous decades, according to the latest results from the Fulcrum nowcasts of global activity.

However, compared to the more recent past, a better assessment would be “solid at the trend growth rate”. Although that trend growth rate is disappointingly low, it is no longer falling (according to the models), and the actual growth rate is no longer below trend, so the global margin of spare resources in no longer increasing. Read more

Until recently, the rate of expansion in global central bank balance sheets seemed likely to remain extremely high into the indefinite future. Although the US Federal Reserve had frozen its balance sheet, both the European Central Bank and the Bank of Japan were pursuing open-ended programmes of asset purchases, and the Bank of England actually increased its intended stock of assets by £50bn in August. Global central bank balance sheets were rising by about 2 percentage points of GDP per annum – a similar rate to that seen since 2012.

Some commentators argued that the central banks would never step aside from their programmes of balance-sheet expansion. After QE1, 2 and 3, we would get “QE infinity”. Others argued that unlimited quantitative easing would result in disaster, either through rapidly rising inflation, or bubbles in asset markets.

Neither of these dark outcomes has occurred. Instead, it seems that policy makers are moving away from QE because it is no longer effective and no longer necessary. “QE infinity” is coming to an end, not with a bang but with a whimper. Read more

The likelihood that Donald Trump will win the US Presidency fell markedly last week, following Hillary Clinton’s performance in the opening television debate. But according to Nate Silver in the 538 blog, it still remains 32 per cent likely that Trump will win, and the betting markets put the probability just below 30 per cent. In other words, it is a somewhat improbable event, not a remote possibility. Just before the recent UK referendum, a victory for Brexit was considered more unlikely than a Trump victory is considered today.

The consequences of a Trump victory are widely regarded by mainstream economists as catastrophic. Martin Wolf says that it would be a disaster for western democracy, and surveys suggest that most investors believe that it would be bad for all US assets – equities, bonds and the dollar.

Yet markets have not generally been very sensitive to recent swings in the opinion polls. There has been a mild tendency for US equities to rise when Secretary Clinton is doing well but only the Mexican peso has been very responsive to the election, repeating the sensitivity of sterling to Brexit polls during the UK referendum.

Why have US markets generally been willing to ignore the Trump risk? And would this continue in the event of a surprise win for the Republican candidate? Read more

Fiscal policy activism is firmly back on the agenda. After several years of deliberate fiscal austerity, designed to bring down budget deficits and stabilise public debt ratios, the fiscal stance in the developed economies became broadly neutral in 2015. There are now signs that it is turning slightly expansionary, with several major governments apparently heeding the calls from Keynesian economists to boost infrastructure expenditure.

This seems an obvious path at a time when governments can finance public investment programmes at less than zero real rates of interest. Even those who believe that government programmes tend to be inefficient and wasteful would have a hard time arguing that the real returns on public transport, housing, health and education are actually negative [1].

With monetary policy apparently reaching its limits in some countries, and deflationary threats still not defeated in Japan and the Eurozone, we are beginning to see the emergence of packages of fiscal stimulus with supply side characteristics, notably in Japan and China.

Investors are asking whether this pivot towards fiscal activism is a reason to become more bullish about equities and more bearish about bonds, on the grounds that the new policy mix will be better for global GDP growth. This is directionally right, but it is important not to exaggerate the extent of the pivot. Read more

As investors anxiously await the key monetary policy decisions from the Federal Reserve and the Bank of Japan next week, there have been signs that the powerful rally in bond markets, unleashed last year by the threat of global deflation, may be starting to reverse. There has been talk of a major bond tantrum, similar to the one that followed Ben Bernanke’s tapering of bond purchases in 2013.

This time, however, the Fed seems unlikely to be at the centre of the tantrum. Even if the FOMC surprises the market by raising US interest rates by 25 basis points next week, this will probably be tempered by another reduction in its expected path for rates in the medium term.

Instead, the Bank of Japan has become the centre of global market attention. The results of its comprehensive review of monetary policy, to be announced next week, are shrouded in uncertainty. So far this year, both the content and the communication of the monetary announcements by BoJ governor Haruhiko Kuroda have been less than impressive, and the market’s response has been repeatedly in the opposite direction to that intended by the central bank.

As a result, the inflation credibility of the BoJ has sunk to a new low, and the policy board badly needs to restore confidence in the 2 per cent inflation target. But the board is reported to be split, and the direction of policy is unclear. With the JGB market now having a major impact on yields in the US, that could be the recipe for an accident in the global bond market. Read more

The equilibrium real rate of interest, or R* in the jargon of macro economists, has moved into the centre of the debate about monetary policy in the US. Macro investors have become very familiar with the concept over the past couple of years, because it is clear that it is driving the Federal Reserve’s attitude towards the normalisation of US monetary policy.

Recently, the frequent mention of the concept in the minutes of the FOMC has forced it into the minds of a much wider field of investors, who do not need reminding that the Fed is still the key player driving global asset prices in the medium term. Anything that matters to the Fed matters to all investors.

But many people are still confused by R*. This blog is intended to clarify the somewhat obscure, but critically important, concept of R*. It is written in a Q&A format. Read more

In last month’s report on the Fulcrum nowcasts for global economic activity, we documented a marked pick-up in growth rates in many big economies, ending a prolonged period in the doldrums. At that time, global growth was running slightly above its trend rate, and the widespread nature of this improvement led us to ask whether the world economy might be approaching escape velocity for the first time since 2010.

Although our answer to this question was “probably not”, the mere fact that we posed the question at all was seen as ridiculously optimistic by some commentators. The general view among economists seemed to rule out even a short term, cyclical upswing in activity in present deflationary conditions.

The financial markets, however, have been more hopeful that a phase of moderate cyclical growth may be taking hold, after the powerful contractionary forces of the previous 18 months have started to abate. Global equities have risen by about 6 per cent since the upswing in world activity became apparent in June, and bond returns have been slightly negative.

In August, we have received no confirmation that a cyclical upswing is gaining momentum. But nor has there been a significant decline in activity: the jury is still out

The FTPL is normally wrapped in impenetrable mathematical models, and it has therefore remained obscure, both to policy makers and to investors. But the subject is now moving centre stage, as Prof Sims’ lucid explanation makes very apparent. It has important implications for the conduct of macro-economic policy, especially in Japan and the eurozone member states.

In these countries, Prof Sims is challenging the claim that further quantitative easing can achieve the 2 per cent inflation target, without explicit co-operation with the government budget. In the US, he is disputing Ms Yellen’s assertion last week that the Fed has further unconventional monetary weapons in reserve if the economy is hit by negative shocks in the future. Read more

Several commentators (see here, here and here) have noted recently that the Federal Reserve has made a major shift in its attitude towards the future path for US interest rates. When the FOMC increased rates last December, they seemed quite confident that the 0.25 per cent hike was the first in a long line of similar increases each quarter, driven by the need to “normalise” interest rates gradually over time.

At that stage, they also seemed fairly sure that they knew what “normal” meant. Now, they seem to have lost that certainty, and have simultaneously shifted their central assessment of the “normal” level for short rates sharply downwards. This has not surprised the markets, which moved in that direction well ahead of the FOMC. But it has strengthened the conviction among investors that the doves are now firmly in control at the Fed.

Last week, Ben Bernanke released an important blog, analysing the main reasons for the FOMC’s change of view, and largely giving his seal of approval. Although the former Fed President has of course been inclined towards dovishness ever since 2008, it is significant that he views the shift as being underpinned by deep fundamental forces inside the US economy, not by minor fluctuations in incoming economic data.

Mr Bernanke is certainly right that domestic fundamentals have changed, but I think his blog has underplayed another significant reason for the Fed’s shift, which is a dawning realisation that events in foreign economies are far more important in determining the equilibrium level of US rates than has previously been accepted. In fact, this has probably been the main factor in the Fed’s U-turn this year. Until this changes, the Fed will err on the dovish side whenever a key decision is taken. Read more

The latest Fulcrum nowcasts for global economic activity have identified a broad pick-up in growth in many major regions, both in the advanced economies and the emerging markets. The latest estimate shows global activity expanding at an annualised rate of 4.1 per cent, a marked improvement compared to the low point of 2.2 per cent recorded in March, 2016.

The synchronised nature of this improvement in growth is notable. Not only have the risks of a global recession in the forthcoming months fallen sharply, there are now some early indications that the world economy could be moving into a period of above trend expansion for the first time since early 2015. Read more

Ever since the crash of 2008, the global financial markets have been subject to prolonged periods in which their behaviour has been dominated by a single, over-arching economic regime, often determined by the stance monetary policy. When these regimes have changed, the behaviour of the main asset classes (equities, bonds, commodities and currencies) has been drastically affected, and individual asset prices within each class have also had to fit into the overall macro pattern. For asset managers of all types, it is therefore important to understand the nature of the regime that applies at any given time.

This is not easy to do, even in retrospect. There will always be inconsistencies in asset performance which cause confusion and require interpretation. Nevertheless, it is an exercise which is worth undertaking, because it can bring a semblance of order to the apparent chaos of asset markets.

Two main regimes have been in place in the asset markets of developed economies since 2012. (The emerging markets also fit the pattern, with some slight differences.)

These regimes are, first, the period in which quantitative easing was the dominant factor, from 2012 to mid 2015; and, second, the period in which deflation risk has been the dominant factor, from mid 2015 to now.

It is possible that the markets are now exiting the period of deflation dominance, and they may even be entering a new regime of reflation dominance, though this is still far from certain. Secular stagnation is a powerful force that will be hard to shake off. But if that did happen, the pattern of asset price performance would change substantially compared to the recent past. Read more

The yen recorded its sharpest drop in the past three decades last week, as markets sniffed the possibility of helicopter money arriving in Japan. The meetings of “Helicopter Ben” Bernanke with Bank of Japan officials, and then with Prime Minister Shinzo Abe, were the latest trigger for this speculation, but in reality the Japanese authorities have been revving up the helicopters for some while, and they seem to be running out of alternatives.

Whether or not they choose to admit it – which they will probably resist very hard – the Abe government is on the verge of becoming the first government of a major developed economy to monetise its government debt on a permanent basis since 1945.

Why is it opting for this macro-economic policy of the last resort, and will it work? Read more

on macroeconomics

Gavyn Davies is a macroeconomist who is now chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners. He was the head of the global economics department at Goldman Sachs from 1987-2001, and was chairman of the BBC from 2001-2004.

He has also served as an economic policy adviser in No 10 Downing Street, an external adviser to the British Treasury, and as a visiting professor at the London School of Economics.

Gavyn Davies is an active investor and may have financial interests and holdings in any of the topics about which he writes. The views expressed are solely those of Mr Davies and in no way reflect the views of Prisma Capital Partners LP, Fulcrum Asset Management LLP, their respective affiliates or representatives. This material is not intended to provide, and should not be relied upon for, investment advice or recommendations.

Readers are urged to seek professional advice before making any investments.